Is The Bond Hangover Cure of Inflation Worse Than The Disease?

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Uncharacteristically for an economist, Wolfgang Munchau questions the conventional remedy for the debt millstone: use inflation to trash its value in real terms. Bondholders so often get shafted that it’s a predictable outcome.

But is it wise? Munchau argues that regardless, the piper must be paid. If the powers that be succeed in creating meaningful inflation, they will have to engineer a contraction to wring it out of the system. Volcker demonstrated how painful that could be. The retort is that the all in costs may well be worse that if we muddled along with less aggressive remedies.

But human beings in general, and politicians in particular, do not discount future events the way finance textbooks say they ought to. They engage in hyperbolic discounting. So future costs are vastly cheaper than pain now, particularly if you can dump the mess on a successor.

From the Financial Times:

What I hear more and more, both from bankers and from economists, is that the only way to end our financial crisis is through inflation…

Four immediate questions arise from these considerations. Can it be done? Can it be undone? Can it be done at a reasonable economic cost? Last, should it be done?

Of course, it can be done, but only for as long as the commitment to higher inflation is credible. Inflation is not some lightbulb that a central bank can switch on and off. It works through expectations. If the Fed were to impose a long-term inflation target of, say, 6 per cent, then I am sure it would achieve that target eventually. People and markets might not find the new target credible at first but if the central bank were consistent, expectations would eventually adjust. In the end, workers would demand wage increases of at least 6 per cent each year and companies would strive to raise their prices by that amount.

If, however, a central bank were to pre-announce that it was targeting 6 per cent inflation in 2010 and 2011, and 2 per cent thereafter, the plan would probably not succeed. We know that monetary policy affects inflation with long and variable lags. Such a degree of fine-tuning does not work in practice. My own guess is that one would have to make a much longer-term commitment to a higher rate of inflation for such a policy shift to be credible. I suspect that the greater the distance between the new rate and the current rate, the longer the commitment would have to be.

Could it be reversed, once it had been achieved? Again, the answer is yes; again, the commitment would have to be credible….any new credibility would have to be earned through new policy action. This might imply nominal interest rates significantly above 6 per cent for an uncomfortably long period.

What would happen then? I can think of two scenarios. The best outcome would be a simple double-dip recession. A two-year period of moderately high inflation might reduce the real value of debt by some 10 per cent. But there is also a downside. The benefit would be reduced, or possibly eliminated, by higher interest rates payable on loans, higher default rates and a further increase in bad debts. I would be very surprised if the balance of those factors were positive.

In any case, this is not the most likely scenario. A policy to raise inflation could, if successful, trigger serious problems in the bond markets. Inflation is a transfer of wealth from creditors to debtors – essentially from China to the US. A rise in US inflation could easily lead to a pull-out of global investors from US bond markets. This would almost certainly trigger a crash in the dollar’s real effective exchange rate, which in turn would add further inflationary pressure.

Under such a scenario, it might not be easy to keep inflation close to a hypothetical 6 per cent target. The result could be a vicious circle in which an overshooting inflation rate puts further pressure on the bond markets and the exchange rate. The outcome would be even worse than in the previous example. The central bank would eventually have to raise nominal rates aggressively to bring back stability. It would end up with the very opposite of what the advocates of a high inflation policy hope for. Real interest rates would not be significantly negative, but extremely positive.

Should this be done? A credible inflation target of 2 or 3 per cent, maintained over a credibly long period of time, is useful. But I doubt that a 6 per cent inflation target could be simultaneously credible and sustainable. Tempting as it may be, it is a beggar-thy-neighbour policy unless replicated elsewhere and would come to be regarded as such by many countries in the world. It would produce a whole new group of losers, both inside and outside the US, with all its undesirable political, social, economic and financial implications. It would also fuel the already rampant discussions about the inevitable death of fiat money.

Stimulating inflation is another dirty, quick-fix strategy, like so many of the bank rescue packages currently in operation. As Hemingway said, it would feel good for a time. But it would solve no problems and create new ones

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You may have noticed a crucial assumption….”workers will demand wage increases.” Pray tell, how? Workers have no bargaining power in the US. Merely goosing interest rates does not a a tight labor market make.

Stagflation was seen as impossible until it took place. I wonder if we could wind up with rising bond yields due to concerns about large fiscal deficits, with a lower rate of goods inflation due to the lack of cost push (wages are a significant component of the cost of most goods, save highly capital intensive ones). In fact, we could see stagnant nominal wages with mildly positive inflation, which means wage deflation. If that was also accompanied by high yields, you would have much of the bad effects of debt deflation per Irving Fisher (high real yields and reduced ability to service debt) since real incomes would be falling in the most indebted cohort.

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16 comments

  1. Francois

    “You may have noticed a crucial assumption….”workers will demand wage increases.” Pray tell, how? Workers have no bargaining power in the US. Merely goosing interest rates does not a tight labor market make.”

    If workers, who are already stretched very thin, would see their purchasing power eroded yet again and would be unable to negotiate raises, what do you think would happen?

    We would have a transition from frustration and anger to despair and rage. This is a very explosive social cocktail that no amount of spin for the powers that be and their enablers at the Amerikan Izvestia (read: Beltway punditocracy) would be able to tamper.

    One could then see a huge cleanup in DC come election time, a cleanup that would shell-shock the political class to the core.

    I’ll leave to others the task of examining the “alternatives” to this scenario. Suffice to say that none would be pretty.

  2. attempter

    You may have noticed a crucial assumption….”workers will demand wage increases.” Pray tell, how? Workers have no bargaining power in the US. Merely goosing interest rates does not a a tight labor market make..

    It’s clear that any administration, Rep or Dem, assumes it will be able to prop up the highly unequal system at the expense of the workers. That’s why every policy of the last 35 years has had the intention and effect of depressing real wages.

    The idea has always been to buy off the people by enabling them to expand consumer debt, which by ideological dogma was assumed to be infinitely sustainable. And we can see that this is still the dogma, since literally every notion of financial and economic policy (and by extension every other kind of policy) today is still predicated on the pseudo-idea of finding new bubbles.

    At the same time that they hooked the people on debt as “consumers”, they were gutting the unions, crippling them as politically effective workers. An employee deep in debt is not likely to get uppity anyway.

    Now we also have the ever-growing army of the unemployed. The system will count on fierce cannibalistic struggle among these for whatever crumbs are thrown to them. Again the dynamic is counter-organization.

    Finally, by now the American people seem terminally mired in conformism, brainwashing, self-enslavement. There seems to be no revolutionary human fibre anywhere.

    Put this all together, and we can see how dismal the current prospects are for anything but a long term further social devolution into ever greater wrtechedness, while the super-rich and the feudal corporations only concentrate further wealth.

  3. Charles

    “”workers will demand wage increases.” Pray tell, how? Workers have no bargaining power in the US. Merely goosing interest rates does not a a tight labor market make. “If surplus countries move against the dollar by selling them when goods are exported to the US, the US will reciprocate by erecting trade barriers (the “be-careful-what-you-wish-for” reasoning will be “our currency is battered because of our unsustainable trade deficit, so we must restrict import to restore the value of the dollar”). Of course, it won’t work, but once one has trade barriers in place, workers bargaining power is restored : stagflation guaranteed !

    Still, the “hangover” problem is real. It is the precise reason why it is preferable to have an institutional framework that allows for negative nominal rates.
    If that was possible, you could get one or two years @ -5% to -2% that would be equivalent to Rogoff’s 6%inflation for two years.
    But the big difference is that one wouldn’t have tinkered with inflation expectations.
    I therefore think Buiter’s multiple posts on the matter really need to be carefully considered.

    I understand that you fear popular backlash against the main issue for implementing negative nominal rate, which is suppressing cash banknotes. However, if you frame the story as cash mainly of use to tax cheats, criminals and terrorists – which actually is not far from the truth… -, you can get public support for it. After all, if people are prepared to accept queuing hours in airports for safety controls, they should be ready to accept that 100% of their consumption (instead of the current 90% to 95%) is settled with bank transfers and plastic.

  4. Jaime

    Rather than a cleanup in DC, what I see is a wipe out in DB (or public pensions in Europe) coming…

  5. wintermute

    There is a solution to politicians love of “hyperbolic discounting”.

    A law that politicians (government) pensions are not allowed to be indexed to inflation.

  6. Bandarlog

    Actually, I think it IS 'some lightbulb.'

    Everyone is already over-levered, so there is no demand for more debt. (As of the last Sr Loan Officer Survey the gap between the rate at which demand for both C&I and consumer credit is declining relative to supply has not been higher since our troubles started.) Without demand for more debt, the Fed can 'print' all the money it wants, but no one besides gubment will borrow and spend it, and private sector borrowing is how money really gets printed in US and A. As long as this is the case inflation is not possible.

    HYPERinflation IS possible. That's not the same thing as a whole lot of inflation that started at 2% and "grew" to 1,000,000%. It's an entirely different phenomenon, driven by expectations that WILL pretty much click on like a lightbulb at the moment the central bank convinces the monkeys intermediating our savings it is serious about debasing the currency whatever it costs. It's exemplified by James Hamilton's discussion here:

    http://www.econbrowser.com/archives/2008/10/deflation_risk.html

    Just buy up all the US treasuries, buy as much CP as anyone cares to issue, all the shares in Tokyo… "[I]f inflation is what you want, put me in charge of the Federal Reserve and believe me, I can give you some inflation."

    That's not inflation. It doesn't even raise the the question of how to "tighten" to "wring out" the system. You'd have to rebuild the system from scratch. But if this is the road the Fed goes down the necessary expectations probably will click on like a lightbulb.

  7. sanjay

    I think the most serious cost of inflation getting out of control has been missed- political stability. While the risk of that may be small the consequences are great- think Weimar and the Nazis.

    Policy makers first and foremost concern should be the preservation of the constitution- an oath that they have taken.

  8. Benign Brodwicz

    Agreed: the labor market has been beaten down by the ruling class.

    Bernanke’s first bubble is likely to be an asset bubble, possibly a stock market bubble, after a correction. The Wall Street ruling class (I am am convinced the inferences of market manipulation of the stock market are correct) will use this as an opportunity to further clean out the middle classes.

    See http://animalspiritspage.blogspot.com/2009/05/bens-first-bubble.html

  9. Mark

    Left-wing observers have felt for a while that Obama will be an agent of austerity for the middle and working classes. Clinton brought austerity (welfare reform) to the under-class so the precedent exists.

    I doubt that the ruling class will do anything extreme that would risk the viability of their vampire system.

  10. ronald

    ..”workers will demand wage increases.

    Manufacturing automation has and will continue to reduce floor labor. Overhead costs are related to keeping the machines running 24/7 which requires sales velocity.
    Overhead wages so to speak is in demand creation and with the reality that credit availability in all forms including vendor financing is the primary sales driver one should expect cost cutting throughout the complex marketing industry as the realization that its more important to offer financing then 20 color choices will further trim the bloated white collar overhead. Hard to see wage inflation while the government consumes available capital and business/consumer credit standards tighten further, fueling unemployment.

  11. Bob Goodwin

    We have a $10B debt deflation hole, and a $2B deficit. The government has never threatened engineered inflation, nor will they. Since no tax increases will occur during a depression, the fed will simply buy $2B in treasuries, plus whatever China insists on selling. This still does not fill the $10B hole.

    Thus there will be no pricing power for manufacturers or labor. Your $100,000 salary will remain $100,000, and your $3 milk will remain $3. But labor and China will become poorer, because the net deflation will reduce the value of assets (homes, stocks and bonds). It won’t be inflation, but we all will be poorer.

    If you think this analysis neglects rest-of-world, I would counter that the debt deflation is world-wide, and that the US will debase its currency about the same as every other currency gets debased. We all get poorer, but will have about the same amount of cash and milk.

  12. Hugh

    I think that inflation or a partial default are still the two likeliest ways that the US economy will deal with its international debt obligations. Export oriented countries that sold to the US for the last several years should have known that this was a down the road consequence of their own trade policies.

    Somehow I can’t muster a lot of sympathy for those who ignore the obvious. As for Munchau, it’s easy to warn about the difficulties in controlling inflation but does he have an alternative?

  13. Tortoise

    For the stimulus to be effective, it MUST be financed with “new” money that is “printed” by the Fed. If the stimulus were supported by money moved from savings accounts to buy US bonds, it would not work.

    The unwillingness of private bond buyers to buy US bonds is a GOOD thing, in a certain way and certainly not for everyone. It shows confidence that the economy will recover soon and deflation expectations are on the way out.

    The question in front of us is whether an economic recovery is around the corner. My bet is that there is a 90% probability that the economy will be growing at a decent pace by the fourth quarter. The recession does not end when all the problems of the world are solved but rather “in the fullness of time”. Which means, in more technocratic terms, when some mild conditions are met.

    On this Memorial-Day weekend, let us briefly review the situation of households in comparison with that of one year ago. For many Americans, life is definitely harder. However, most Americans still have a job and are not in risk of foreclosure on their primary residence. They are seeing that their cash flow picture has improved compared to a year ago. Between a remarkable drop in gasoline prices and a collapse in the interest rate they pay on credit lines, they see more money left in their checking account at the end of each month. Prices of cloths or vacation packages are down 30-40% compared to a year ago. (Of course, for example, the state universities in California increased their tuition by 10%, so on the average, we do not have deflation.) I really doubt that consumption will drop any more because, for the first time in about ten years, it looks as if consumers are spending roughly in accordance with their incomes.

    Housing may not lead us out of the recession the way it used to but I expect that even housing will make a positive contribution. How is that possible when it looks like houses may drop in price another 20 percent? Houses require non-stop maintenance and upgrading. Households will soon decide to spend to replace rotten lumber or paint some rooms or remodel a bathroom. Even construction of new housing will pick up as there is tremendous need for smaller but comfortable homes.

    Last but not least, I will not be surprised if growth in Asia leads the world out of this recession. Just look at oil prices (WTI at $61) and shipping (Baltic Dry Index is at 2,800). The world economy is not falling off a cliff, despite all you may have heard.

  14. juan

    They are seeing that their cash flow picture has improved compared to a year ago. Between a remarkable drop in gasoline prices and a collapse in the interest rate they pay on credit lines, they see more money left in their checking account at the end of each month.I appreciate the optimism, but:

    -BLS reports that seasonally adjusted, CPI-W deflated, real weekly earnings rose 2.6% yoy in April – unadjusted the rise was four dollars and one penny, essentially nil.
    http://www.bls.gov/news.release/pdf/realer.pdf

    -Debt service and household financial obligation ratios through 4Q08 are very slightly down from earlier and, I believe, record high levels.
    http://www.federalreserve.gov/releases/housedebt/

    -Over the last year, 63% of small business owners have experienced higher credit card rates, 41% have had their credit limit reduced and 23% have had fixed rates converted to variable. [Which has also been taking place across a broader spectrum].
    http://www.businessweek.com/smallbiz/running_small_business/archives/2009/05/small_business_7.html

    -On a global basis, the ILO has reported tendential wage decline relative to growth:

    “For the world’s 1.5 billion wage-earners, difficult times lie ahead”, says ILO Director-General Juan Somavia. “Slow or negative economic growth, combined with highly volatile food and energy prices, will erode the real wages of many workers, particularly the low-wage and poorer households. The middle classes will also be seriously affected”.
    […]

    Based on an analysis of major trends in the level and the distribution of wages around the world in recent years, the ILO report shows that while wage growth has lagged behind overall economic growth during upswings, it slowed down more rapidly during economic downswings. According to the report, between 1995 and 2007, for each 1 per cent decline in GDP per capita, average wages fell even further by 1.55 percentage point – a result that points to the possible effects on wages of the current crisis.http://www.ilo.org/global/About_the_ILO%20/Media_and_public_information/Press_releases/lang–en/WCMS_100783/index.htm

    -More recently [March], the same organization noted:

    In early 2009, a global jobs catastrophe is in the making. On current trends, global unemployment and the number of working poor are forecasted to
    rise significantly in the course of this year. In addition, some 90 million people will enter the labour market worldwide in 2009-10.
    […]
    As the crisis continues to spread and job losses mount, worldwide unemployment could increase by at least 38 million by the end of this year.
    […]
    Social hardship will be heightened in developing countries where social protection is often limited. But even in emerging economies and a number
    of developed countries, most new jobseekers do not receive unemployment benefits. The result is that millions of workers will be left without adequate support.
    http://www.ilo.org/public/english/bureau/inst/download/tackling.pdf

    Which, from the perspective of a global crisis of overproduction, strikes me as less severe than will likely be the case.

    All of the ‘doing this, doing that’ solutions seem to avoid the possibility of uncontrollability, i.e. limits to policy coordination and effectiveness. This did not begin as a financial crisis but in the declining growth rate and weak profitability of the long slowing. That it has been treated as ‘financial first, then real’ helps exemplify multiple levels of failure or acceptance of illusion.

  15. Rod

    Wolfgang Münchau opens his piece with a quote from Ernest Hemingway. But inflation and war occurred together in the 20th century. Naked capitalism used war to rescue itself -but that was not all. War and inflation are profitable (as shown by World Wars I and II), and first generates the second. The present inflationary danger is therefore associated with the danger of escalating war.

  16. Paul

    My experience with economics classes at very good universities left me with the impression that even the best teaching economist PhD’s repeat dogma that is often at odds with common sense. Example – it is not possible to have full employment without rampant inflation. Nonsense, as history has borne out.

    Economics is not a science. The scientific method, which rescued us from the dark ages, does not apply to economics.

    As the Wolfgang Munchau excerpt illustrates, even the most erudite economist sounds like little more than a puffy wanker spinning masturbatory hypotheticals that go no where.

    At best, economics is a loose collection of conventions that have no absolute underpinning. Given a change in the status du jour, and the flimsy interelationships crumble, awaiting an equilibrium that one can agaian hang bogus hypotheses on until the next change illustrates how nonsensical they are.

    If the Marx Brothers were alive today, surely they would lampoon these ridiculously self important charlatans.

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